Trade is the exchange of products between countries. When conditions are right, trade brings benefits to all countries involved and can be a powerful driver for sustained GDP growth and rising living standards

One way of expressing the gains from trade in goods and services is to distinguish between static gains (i.e. improvements in allocative and productive efficiency) and dynamic gains (i.e. gains in welfare that occur from improved product quality, increased choice and faster innovative behaviour).

Gains from Trade – Understanding Comparative Advantage

First introduced by David Ricardo in 1817, comparative advantage exists when a country has a ‘margin of superiority’ in the supply of a good or service i.e. where the marginal cost of production is lower

Countries will generally specialise in and export products which use intensively the factors inputs which they are most abundantly endowed

If each country specializes, total output can be increased leading to better allocative efficiency and welfare.

Because production costs are lower, providing that a good price can be found from buyers, specialisation should focus on goods and services that provide the best value

In many countries, comparative advantage is shifting towards specialising in producing and exporting high-value and high-technology manufactured goods and high-knowledge services

Example of Comparative Advantage

Usually we take a standard two-country + two-product example to illustrate comparative advantage.

  • Consider two countries producing digital cameras and vacuum cleaners
  • With the same factor resources (inputs) evenly allocated by each country to the production of both goods, the production possibilities are as shown in the table below:
OUTPUT BEFORE SPECIALISATION Digital Cameras Vacuum Cleaners
UK 600 600
United States 2400 1000
Total 3000 1600
Stage 1: Working out the comparative advantage
  • To identify who should specialise in a particular product, consider the internal opportunity costs
  • Were the UK to shift their resources into supplying more vacuum cleaners, the opportunity cost of each vacuum cleaner is one digital television
  • For the United States the same decision has an opportunity cost of 2.4 digital cameras. Therefore, the UK has a comparative advantage in vacuum cleaners
  • If the UK chose to reallocate resources to digital cameras the opportunity cost of an extra camera is one vacuum cleaner. But for the USA the opportunity cost is only 5/12ths of a vacuum cleaner.
  • USA has comparative advantage in producing digital cameras because its opportunity cost is lowest

Stage 2: Showing the Output after Specialisation

output after specialisation Digital Cameras Vacuum Cleaners
UK 0 (-600) 1200 (+600)
United States 3360 (+960) 600 (-400)
Total 3360 1800
  • The UK specializes totally in producing vacuum cleaners – doubling its output - now1200
  • The United States partly specializes in digital cameras increasing output by 960 having given up 400 units of vacuum cleaners
  • As a result of specialisation output of both products has increased - a gain in economic welfare.
Key point:

For mutually beneficial trade to take place, the two nations have to agree an acceptable rate of exchange of one product for another. If the two countries trade at a rate of exchange of two digital cameras for one vacuum cleaner, the post-trade position will be as follows:

  • The UK exports 420 vacuum cleaners to the USA and receives 840 digital cameras
  • The USA exports 840 digital cameras and imports 420 vacuum cleaners

Stage 3: Showing the Gains from Trade - Post Trade Output / Consumption

 Digital CamerasVacuum Cleaners
UK840780
United States25201020
Total33601800

Compared with the pre-specialisation output levels, consumers now have an increased supply of both goods

Exam tip: It is useful to learn a numerical example to illustrate comparative advantage for use in an exam

What are the key assumptions behind this theory of trade?

This theory of trade based on comparative advantage rests on a number of assumptions:

  1. Occupational mobility of factors of production (land, labour, capital) - this means that switching factor resources from one industry to another involves no loss of efficiency and productivity. In reality we know that factors of production are not perfectly mobile – labour immobility is a root cause of structural unemployment.
  2. Constant returns to scale (i.e. doubling the inputs used in the production process leads to a doubling of output) – this is merely a simplifying assumption. Specialisation might lead to diminishing returns in which case the benefits from trade are reduced. Conversely increasing returns to scale means that specialisation brings even greater increases in output.
  3. Insignificant externalities from production and/or consumption – no discussion about the overall costs and benefits of specialisation and trade should ignore environmental considerations arising from increased production and trade between countries.
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